Chris Hansen

Real estate offers investors an opportunity, not available in other types of assets such as bonds or shares, to add additional value to their original investment through asset development, refurbishment or enhancement initiatives.

For investors who do not want to just ‘buy the market’ building, refurbishing or improving property can be expensive, but done smartly, it can be well worth the capital outlay. Indeed, as markets run hot, now is an opportune time for property owners to look at development opportunities in their portfolios.

Why develop?
There are a number of benefits that accrue to the various stakeholders within the development process. Developments can help revitalise local areas and neighbourhoods, provide jobs before, during and after construction, and the economic benefits can spread up and down the supply chain.

Private investors investing in a development or asset enhancement initiative will usually only proceeds when they believe the opportunity will provide them with an appropriate risk-adjusted return.

While the level of return each may seek will be bespoke to their particular situation, the return for commercial office development is generally realised through the delivery of a higher quality asset, in a good location, supported by improved amenity which in turn will attract a strong, or stronger, tenant covenant. The asset is then valued based on the security of this income over the duration of the hold period and eventually the development profit when it’s sold.

Workplaces drive change
Workplaces were evolving even before COVID-19. The pandemic has simply accelerated the process and many tenants are proactively reviewing their future office requirements, from location to amenity and the design and use of space as well as sustainability, wellbeing and health and fitness benefits.

To attract and retain quality tenants, landlords need to continue to provide versatile and well-managed environments that allow tenants to maintain a positive workplace culture while balancing work-from-home arrangements and facilitating the safe return of employees to the office.

Enhanced technology is a critical factor for improving building services infrastructure and operations and the customer experience of the occupants. Properties that can better service tenants’ requirements will be more desirable, allowing them to secure quality tenants and reliable cashflows than those that do not. This will make them more appealing to investors when the time comes to sell.

Managing risk
Development can be expensive but, with a good development strategy, the uplift in yield and capital value more than compensates for the cost.

An integrated approach to risk management is key. This requires expertise in development, project management and sustainability, as well as technical knowledge and skills and an in-depth understanding of what prospective tenants and the market are looking for. Being able to identify attractive locations and submarkets, down to specific streets and buildings, also helps minimise risk.

Cromwell’s redevelopment of 19 National Circuit, Canberra is a good example. With a 20-year history of investing in the ACT, Cromwell was comfortable progressing a development given the site’s location in the tight Barton market. The property is within close proximity of Parliament House and other key federal government agencies and opposite the National Press Club of Australia. There is hotel accommodation both adjacent to, and across from, the site.

Deep and ongoing working relationships with tenants are also invaluable. Understanding tenants’ changing requirements not only assists in retaining occupancy, it also provides opportunities to create value and informs development decisions.

Cromwell’s proposed development at 475 Victoria Avenue, Chatswood, which seeks to increase the precinct’s floorspace with an additional commercial offering and alternative to the existing commercial towers, has been heavily influenced by a rethinking of the modern workplace for the benefit of both existing and future tenants.

The end-of-trip facilities, as well as the heating, ventilation and air-conditioning (HVAC) system upgrade and office foyer refurbishment, in addition to the new commercial office development, have been designed based around key sustainability, safety and hygiene considerations.The project is targeting a minimum 5-Star Green Star rating, as well as a 5-Star NABERS Energy and Water rating. The development will be complemented by the planned Chatswood to Sydenham Metro Rail expansion due in 2024.

A counter to inflation
A development strategy can also help commercial property investors future-proof their investment against inflation. Worldwide, inflation rates have been supressed by the effects of COVID-19, but many experts are forecasting above-average medium-term rates as countries emerge from the pandemic.

Real estate is a hedge against inflation. This is because commercial property leases can include fixed annual rental increases, giving investors an income boost that offsets the effects of higher rates.

Higher inflation also generally signifies increased economic activity, which can lead to increased demand for properties. Higher demand therefore allows landlords to increase rents, particularly if it comes at a time where there is less new construction, which can occur in such environments.

This is due, in turn, to the increase in costs of building materials, making development more expensive, therefore increasing risk in some cases, and ultimately influencing returns. When coupled with higher borrowing costs, new construction can become less attractive, although this does depend on the individual opportunity.

Take control
Investors who respond to changing tenant needs and actively seek to add value through development and asset enhancement initiatives can improve their returns, subject to a keen appreciation and understanding of market conditions. With current low inflation rates and borrowing costs, this is an ideal time for property investors to consider the development opportunities within their portfolios.

Property is one of the favoured investments of Australians due to its potential to provide both income and capital return. Its low volatility relative to other asset classes, such as equities, is a strong attraction.

The different property asset classes

Property is an asset class which is usually separated into two distinct groups – residential and commercial.

Residential property, which can include your own home, holiday home or residential investment property, is the most commonly held type of property investment by volume. Commercial properties are generally used for business purposes and are usually divided into four categories: retail, office, industrial and specialty.

The fundamental difference between commercial and residential property is that commercial property investments are generally made on the basis of yield. The value of a commercial property is based on the income return it will provide to an investor, which is known as the capitalisation rate. The value is affected by factors including the lease terms, quality of tenant and other building attributes.

Various methods to invest

There are a number of ways through which investors can gain exposure to commercial property, ranging from direct investment, private syndicates, pooled professionally-managed property trusts, ASX-listed real estate investment trusts (A-REITs), or unlisted property trusts.

Benefits of investing in an unlisted property trust

There are several benefits investors gain from investing into a commercial property trust:

• Investors’ funds are pooled, providing access to assets they could not otherwise purchase individually, such as large office buildings or major shopping centres;
• Internal gearing is non-recourse to investors, which means if there is a default, the issuer of the debt (usually a bank) can seize the collateral but cannot seek out the investor for any further compensation. This reduces the risk to each individual investor;
• Regular income stream, with distributions ranging from monthly to six-monthly payments;
• Investors share in any capital growth, proportional to their holding in the trust;
• Potential for tax-deferred income, increasing investors’ after-tax return;
• Professional management, covering due diligence, debt, property and tenant management;
• Liquidity (dependent on the structure used); and
• Only a small investment is required, allowing investors to more easily diversify across properties and managers.

How does an unlisted property trust work?

Unlisted property trusts provide an investment with characteristics most like a direct purchase of a commercial property, with the added benefit of professional management.

As unlisted property trusts are generally priced based on the underlying valuation of their property assets, their price volatility is a lot lower than A-REITs and the value of the investment is primarily influenced by movements in the commercial property market rather than by the broader share market.

There are two types of unlisted property trusts, open-end property funds and fixed-term, closed-end property trusts (often referred to as syndicates).

Open-end property funds

Open-end funds don’t have a maturity date or a finite number of units. Instead, they can continue to issue units so long as they raise money, using the new funds to purchase additional properties.

As there is no specific maturity date, to allow investors to exit the investment the fund must have some other method of liquidity. Liquidity is usually provided by holding a portion of the fund’s assets in cash, using new investors’ funds to pay out exiting investors, or selling assets if necessary. This can allow investors to exit at regular intervals.

As with A-REITs, these funds tend to have a number of assets to increase diversification, but it is at the manager’s discretion to buy or sell assets, so investors do not have certainty over the properties they are investing in.

Fixed-term, closed-end property trusts (syndicates)

Syndicates contain one or more properties that will be held for a specified period of time, usually five to ten years. At the end of the specified time, investors will vote on the future of the trust, with the default outcome usually that the property be sold, the trust wound up and investors paid out. Syndicates should be considered illiquid investments and you need to have an expectation that you will remain in the investment for the full investment term.

Market volatility has dramatically increased investor interest in simpler syndicate investment vehicles since the GFC. Syndicates provide a strong proxy for the direct purchase of commercial property. They are generally fairly easy to understand and you know for certain which property (or properties) are going to be owned. Therefore, if you don’t like the property, you simply don’t make an investment in that trust.

Single property syndicates don’t provide any diversification on their own, but because the minimum investment is generally as low as $10,000, you can combine investments in a number of syndicates to provide diversification by property, location, sector and manager.

Ideally, you would also choose syndicates with different maturity dates, so you are not reliant on the property market being strong at a given point in time.

Property management

A key reason for using an unlisted property trust is gaining the expertise of a property manager. The best property fund managers have an internal property management division which looks after the buildings in the trusts it manages. Having this function in-house ensures buildings are managed properly, and their capital value and appeal to current and prospective tenants is maintained.

Property management includes leasing, ongoing maintenance of buildings, building concierge services, fire safety and other compliance requirements and, most importantly for investors, making sure rent is collected! Investors pay for these services, but they will already be taken into account in the forecast distribution rates in the given trust.

Costs and fees

The trust will generally be charged acquisition fees, ongoing management fees, property management fees and various other fees by the manager depending on the individual trust, its assets and structure. The trust is also likely to pay stamp duty for the acquisition of properties plus legal and other costs.

Any returns forecast will take these fees and costs into account. ASIC requires all managers to display their fees and costs in a consistent format in the Product Disclosure Statement (PDS), which makes it easy to compare the fees associated with various unlisted property trusts.

Distributions

The trust will receive rental payments from tenants and this is passed on, less the aforementioned expenses, to unitholders as distributions on a regular basis. Depending on the trust, distributions may be paid monthly, quarterly or six-monthly.

Getting out

Fixed-term trusts

These are essentially illiquid throughout their term unless you or the fund manager can identify someone to purchase your units. At the end of the trust’s term, the property is sold, the trust wound up and investors paid out proportionately to the units they hold.

Open-end funds

Each open-end property fund will have a different liquidity mechanism, but as the underlying property assets are illiquid, the ability to exit the fund will have limitations. Common ways of providing some liquidity is to hold some of the fund’s assets in cash, using cash from incoming investors or, if demand is high and market conditions allow, selling assets.

Reviewing an unlisted property trust

The manager of an unlisted trust provides you with a lot of information about the trust and its assets in the PDS, so it is important to read and understand it – particularly the ‘Risks’ section. Third-party organisations such as Lonsec and Zenith are also useful, as they provide a detailed review of the trust and its assets.

There are a number of additional aspects of a trust that are worth reviewing. These include the manager, distribution yield, property asset – inclusive of all the considerations within, such as location, building quality, growth, tenants, lease and green credentials – the trust structure, fees, borrowing and more.

For more in-depth information on this topic, download Cromwell’s Essential Guide to Investing in Unlisted Property Trusts at www.cromwell.com.au/essential-guide

Patrick Weightman

The right commercial property investment can deliver strong and sustainable returns over the long term, but not every property has the same potential. Here are seven key features to look for in a stand-out property.

What makes the perfect commercial property investment? The truth is that there is no single right answer. A great deal depends on your investment strategy and the role each asset is destined to play in a larger portfolio – whether as a core income generator or an asset that can be transformed over time to create added value.

Nonetheless, successful investments do tend to have key features in common – features that can only be uncovered by disciplined analysis of each asset’s fundamentals. They all impact asset returns, even when the return hurdles differ between asset types.

Here are seven of the most important features:

1. High quality tenants
Given the role income plays in commercial property returns, finding the right tenants is the first and most important consideration. A reliable tenant, such as a government agency or a sizeable business with a healthy balance sheet and strong cash flow, is the single best guarantee of your future income. They represent the lowest risk in terms of being able to meet their lease obligations and the highest probability of resigning leases due to the cost to them if they relocate. If a property is multi-tenanted, rather than a single-occupancy asset, high-quality tenants can also attract other reliable tenants.

2. Attractive facilities
Tenants are not just attracted by the look and feel of a building. It must provide the services they expect, like functioning lifts, adequate lighting, good air conditioning and a quality fit-out (to name just a few). Beyond expectations of basic services, tenants will be attracted to properties which meet their specific needs. If the location isn’t easily accessible by public transport, more car parking spaces or private transport options (like a regular shuttle bus) will be required.

Adding green infrastructure, like solar power, permeable pavements and green roofs, whilst requiring higher initial capital investment, can reduce outgoings and increase the value of the asset. Meeting a tenant’s green credentials is another way to attract stable, long-term tenants who can only occupy properties which meet their organisation-wide standards.

If sufficient capital has not been set aside to bring the building up to expected standards, and then maintain it, this can have a negative impact on the long-term return of that asset.

3. An appealing location
A property has to be in a location where it can attract and retain tenants to generate the underlying income required. However, that doesn’t mean you should only focus on city centres, or assets in high-density areas. A diversified portfolio is likely to include assets in CBD, metropolitan and regional locations.

Outside of the CBD, regional locations tend to offer more car parks at a lower rate, lower occupancy costs and larger floor plates that support greater workplace efficiencies. Regional locations may also meet needs unique to employment providers in the local area.

CBD locations often have significantly higher land and building costs plus high incentives to win leases. These can all cut into profit margins.

4. The right leasing structure
Most commercial property investors know that a property’s WALE, or “weighted average lease expiry”, can be an important indicator of the security of future cash flows. A higher WALE indicates that tenants (weighted by either rental income or lettable area) are locked into their leases for some time to come. Though long leases with fixed rental increases can provide stability, they may not always deliver the best returns over the life of the asset.

When demand is exceptionally strong, an asset with a short WALE can potentially allow you to reset new or renewed leases at a rate higher than would have been available through fixed rent reviews of either 3% or CPI. Nonetheless, short WALEs do have obvious downsides. They include the capital cost of resetting leases, which can be substantial – especially in markets like Perth and Brisbane, where high tenant incentives are common.

5. The potential for repositioning
A property with tenant vacancy can still be a good investment, as long as you understand the reason for the vacancy and how it can be repositioned to attract new tenants. In fact, assets that offer scope for repositioning can be highly valuable additions to a portfolio, with the potential to improve both yields and valuations through enhanced rental income. Having a vision, knowing your potential tenants and knowing how to reposition an asset to meet both market and tenant requirements is where experience really comes into play.

6. Financial analysis
While leases can be structured so that the tenant pays part, all or none of the outgoings, it’s still important to have a clear understanding of all the outgoings over the life of your investment. Every dollar spent on the asset reduces your potential return, unless it clearly increases the property’s appeal, and thus, it’s long-term value.

If a vendor estimates $1 million in annual outgoings, but your analysis suggests a figure closer to $1.5 million, that difference can have a significant impact on the profitability of the investment – which is why thorough due diligence on a property is absolutely essential.

Equally important is an analysis of the capital expenditure required to maintain, improve or position the asset so it can achieve the rents as forecast.

7. Compatibility with your investment strategy
Finally, but perhaps most importantly, it’s important to assess whether an asset fits your portfolio’s overall asset mix as well as an informed market outlook. For example, an investor with a well-established portfolio might consider a low-cost refurbishment and repositioning opportunity in a location that has unrealised future potential; whereas an investor seeking a core holding might prefer
a proven income-generator in an established area.

Taking a disciplined approach

Finding the right investment takes discipline. An analytical framework that helps identify successful investments and a thorough analysis of each property’s fundamentals can help you effectively make your money ‘on the way in’ to a long-term investment.